The market is in many ways an incredible institution. It allocates resources with an efficiency that no central planning body can match and it easily balances supply and demand. The market has some fundamental weaknesses, however. It does not incorporate into prices the indirect costs of producing goods. It does not value nature’s services properly. And it does not respect the sustainable yield thresholds of natural systems. It also favors the near term over the long term, showing little concern for future generations.

As economic decisionmakers—whether consumers, corporate planners, government policymakers, or investment bankers—we all depend on the market for information to guide us. In order for markets to work and economic actors to make sound decisions, the markets must give us good information, including the full cost of the products we buy. But the market is giving us bad information, and as a result we are making bad decisions—so bad that they are threatening civilization.

The roots of our current dilemma lie in the enormous growth of the human enterprise over the last century. Since 1900, the world economy has expanded 20-fold and world population has increased fourfold. Although there were places in 1900 where local demand exceeded the capacity of natural systems, this was not a global issue. There was some deforestation, but overpumping of water was virtually unheard of, overfishing was rare, and carbon emissions were so low that there was no serious effect on climate. The indirect costs of these early excesses were negligible.

Now with the economy as large as it is, the indirect costs of burning coal—the costs of air pollution, acid rain, devastated ecosystems, and climate change—can exceed the direct costs, those of mining the coal and transporting it to the power plant. As a result of neglecting to account for these indirect costs, the market is undervaluing many goods and services, creating economic distortions.

One of the best examples of this massive market failure can be seen in the United States, where the gasoline pump price in mid-2007 was $3 per gallon. But this price reflects only the cost of discovering the oil, pumping it to the surface, refining it into gasoline, and delivering the gas to service stations. It overlooks the costs of climate change as well as the costs of tax subsidies to the oil industry (such as the oil depletion allowance), the burgeoning military costs of protecting access to oil in the politically unstable Middle East, and the health care costs for treating respiratory illnesses from breathing polluted air.

Based on a study by the International Center for Technology Assessment, these costs now total nearly $12 per gallon ($3.17 per liter) of gasoline burned in the United States. If these were added to the $3 cost of the gasoline itself, motorists would pay $15 a gallon for gas at the pump. These are real costs. Someone bears them. If not us, our children. In reality, burning gasoline is very costly, but the market tells us it is cheap, thus grossly distorting the structure of the economy. The challenge facing governments is to restructure tax systems by systematically incorporating indirect costs as a tax to make sure the price of products reflects their full costs to society and by offsetting this with a reduction in income taxes.

Another market distortion became abundantly clear in the summer of 1998 when China’s Yangtze River valley, home to nearly 400 million people, was wracked by some of the worst flooding in history. The resulting damages of $30 billion exceeded the value of the country’s annual rice harvest.

After several weeks of flooding, the government in Beijing announced a ban on tree cutting in the Yangtze River basin. It justified this by noting that trees standing are worth three times as much as trees cut: the flood control services provided by forests were far more valuable than the lumber in the trees. In effect, the market price was off by a factor of three.

We know from our analysis of global warming, from the accelerating deterioration of the economy’s ecological supports, and from our projections of future resource use in China that the western economic model—the fossil-fuel-based, automobile-centered, throwaway economy—will not last much longer. We need to build a new economy, one that will be powered by renewable sources of energy, that will have a diversified transport system, and that will reuse and recycle everything.

This situation has occasional parallels in the commercial world. In the late 1990s Enron, a Texas-based energy trading corporation, may have appeared on the cover of more business magazines than any other U.S. company. It was spectacularly successful. The darling of Wall Street, it was the seventh most valuable corporation in the United States in early 2001. Unfortunately, when independent auditors began looking closely at Enron in late 2001 they discovered that the company had been leaving certain costs off the books. When these were included, Enron was worthless. Its stock, which had traded as high as $90 a share, was suddenly trading for pennies a share. Enron was bankrupt. The collapse was complete. It no longer exists.

We are doing today exactly what Enron did. We are leaving costs off the books, but on a far larger scale. We focus on key economic indicators like economic growth and the increase in international trade and investment, and the situation looks good. But if we incorporate all the indirect costs that the market omits when setting prices, a very different picture emerges. If we persist in leaving these costs off the books, we will face the same fate as Enron.

As we have seen, a corporate accounting system that left costs off the books drove Enron, one of the largest U.S. corporations, into bankruptcy. Unfortunately, our global economic accounting system that also leaves costs off the books has potentially far more serious consequences.

The key to building a global economy that can sustain economic progress is the creation of an honest market, one that tells the ecological truth. To create an honest market, we need to restructure the tax system by reducing taxes on work and raising them on various environmentally destructive activities to incorporate indirect costs into the market price.

If we can get the market to tell the truth, then we can avoid being blindsided by a faulty accounting system that leads to bankruptcy. As Øystein Dahle, former Vice President of Exxon for Norway and the North Sea, has observed: “Socialism collapsed because it did not allow the market to tell the economic truth. Capitalism may collapse because it does not allow the market to tell the ecological truth.”

The need for tax shifting—lowering income taxes while raising levies on environmentally destructive activities—has been widely endorsed by economists. For example, a tax on coal that incorporated the increased health care costs associated with mining it and breathing polluted air, the costs of damage from acid rain, and the costs of climate disruption would encourage investment in clean renewable sources of energy such as wind or solar. A market that is permitted to ignore the indirect costs in pricing goods and services is irrational, wasteful, and, in the end, self-destructive.

Some 2,500 economists, including eight Nobel Prize winners in economics, have endorsed the concept of tax shifts. Harvard economics professor N. Gregory Mankiw wrote in Fortune magazine: “Cutting income taxes while increasing gasoline taxes would lead to more rapid economic growth, less traffic congestion, safer roads, and reduced risk of global warming—all without jeopardizing long-term fiscal solvency. This may be the closest thing to a free lunch that economics has to offer.”

The first step in creating an honest market is to calculate indirect costs. Perhaps the best model for this is a U.S. government study on the costs to society of smoking cigarettes that was undertaken by the Centers for Disease Control and Prevention (CDC). In 2006 the CDC calculated the cost to society of smoking cigarettes, including both the cost of treating smoking-related illnesses and the lost worker productivity from these illnesses, at $10.47 per pack.

This calculation provides a framework for raising taxes on cigarettes. In Chicago, smokers now pay $3.66 per pack in state and local cigarette taxes. New York City is not far behind at $3 per pack. At the state level, New Jersey—which has boosted the tax in four of the last five years to a total of $2.58—has the highest tax. Since a 10-percent price rise typically reduces smoking by 4 percent, the health benefits of tax increases are substantial.

Tax restructuring can also be used to create an honest pricing system for ecological services. For example, forest ecologists can estimate the values of services that trees provide, such as flood control and carbon sequestration. Once these are determined, they can be incorporated into the price of trees as a stumpage tax. Anyone wishing to cut a tree would have to pay a tax equal to the value of the services provided by that tree. The market for lumber would then be based on ecologically honest prices, prices that would reduce tree cutting and encourage wood reuse and paper recycling.

When Nicholas Stern, former chief economist at the World Bank, released his ground-breaking study in late 2006 on the future costs of climate change, he talked about a massive market failure. He was referring to the failure of the market to incorporate the climate change costs of burning fossil fuels. The costs, he said, would be measured in the trillions of dollars. The difference between the market prices for fossil fuels and the prices that also incorporate their environmental costs to society are huge.

The most efficient means of restructuring the energy economy to stabilize atmospheric CO2 levels is a carbon tax. Paid by the primary producers—the oil or coal companies—it would permeate the entire fossil fuel energy economy. The tax on coal would be almost double that on natural gas simply because coal has a much higher carbon content. As noted in Chapter 11, we propose a worldwide carbon tax of $240 per ton to be phased in at the rate of $20 per year between 2008 and 2020. Once a schedule for phasing in the carbon tax and reducing the tax on income is in place, the new prices can be used by all economic decisionmakers to make more intelligent decisions.

Gasoline’s indirect costs of $12 per gallon provide a reference point for raising taxes to where the price reflects the environmental truth. Gasoline taxes in Italy, France, Germany, and the United Kingdom averaging $4.40 per gallon are almost halfway there. The average U.S. gas tax of 47¢ per gallon, scarcely one tenth that in Europe, helps explain why more gasoline is used in the United States than in the next 20 countries combined.

Phasing in a gasoline tax of 40¢ per gallon per year for the next 12 years, for a total rise of $4.80 a gallon, and offsetting it with a reduction in income taxes would raise the U.S. gas tax to the $4–5 per gallon prevailing today in Europe and Japan. This will still fall short of the $12 of indirect costs currently associated with burning a gallon of gasoline, but combined with the rising price of gasoline itself it should be enough to encourage people to use improved public transport and motorists to buy the plug-in hybrid cars scheduled to enter the market in 2010.

These carbon and gasoline taxes may seem high, but there is at least one dramatic precedent. In November 1998 the U.S. tobacco industry agreed to reimburse state governments $251 billion for the Medicare costs of treating smoking-related illnesses—nearly $1,000 for every person in the United States. This landmark agreement was, in effect, a retroactive tax on cigarettes smoked in the past, one designed to cover indirect costs. To pay this enormous bill, companies raised cigarette prices, bringing them closer to their true costs and further discouraging smoking.

A carbon tax of $240 per ton of carbon by 2020 may seem steep, but it is not. If gasoline taxes in Europe, which were designed to generate revenue and to discourage excessive dependence on imported oil, were thought of as a carbon tax, the $4.40 per gallon would translate into a carbon tax of $1,815 per ton. This is a staggering number, one that goes far beyond any carbon emission tax or cap-and-trade carbon-price proposals to date. It suggests that the official discussions of carbon prices in the range of $15 to $50 a ton are clearly on the modest end of the possible range of prices. The high gasoline taxes in Europe have contributed to an oil-efficient economy and to far greater investment in high-quality public transportation over the decades, making it less vulnerable to supply disruptions.

Tax shifting is not new in Europe. A four-year plan adopted in Germany in 1999 systematically shifted taxes from labor to energy. By 2003, this plan had reduced annual CO2 emissions by 20 million tons and helped to create approximately 250,000 additional jobs. It had also accelerated growth in the renewable energy sector, creating some 64,000 jobs by 2006 in the wind industry alone, a number that is projected to rise to 103,000 by 2010.

Between 2001 and 2006, Sweden shifted an estimated $2 billion of taxes from income to environmentally destructive activities. Much of this shift of $500 or so per household was levied on road transport, including hikes in vehicle and fuel taxes. Electricity is also picking up part of the shift. Environmental tax shifting is becoming commonplace in Europe, where France, Italy, Norway, Spain, and the United Kingdom are also using this policy instrument. In Europe and the United States, polls indicate that at least 70 percent of voters support environmental tax reform once it is explained to them.

Environmental taxes are now being used for several purposes. As noted earlier, landfill taxes adopted by either national or local governments are becoming more common. A number of cities are now taxing cars that enter the city. Others are simply imposing a tax on automobile ownership. In Denmark, the tax on the purchase of a new car exceeds the price of the car itself. A new car that sells for $25,000 costs the buyer more than $50,000. Other governments are moving in this direction. New York Times reporter Howard French writes that Shanghai, which is being suffocated by automobiles, “has raised the fees for car registrations every year since 2000, doubling over that time to about $4,600 per vehicle—more than twice the city’s per capita income.”

Cap-and-trade systems using tradable permits are sometimes an alternative to environmental tax restructuring. The principal difference between them is that with permits, governments set the amount of a given activity that is allowed, such as the harvest from a fishery, and let the market set the price of the permits as they are auctioned off. With environmental taxes, in contrast, the price of the environmentally destructive activity is incorporated in the tax rate, and the market determines the amount of the activity that will occur at that price. Both economic instruments can be used to discourage environmentally irresponsible behavior.

The use of cap-and-trade systems with marketable permits has been effective at the national level, ranging from restricting the catch in an Australian fishery to reducing sulfur emissions in the United States. For example, the government of Australia, concerned about lobster overharvesting, estimated the sustainable yield of lobsters and then issued catch permits totaling that amount. Fishers could then bid for these permits. In effect, the government decided how many lobsters could be taken each year and let the market decide what the permits were worth. Since the permit trading system was adopted in 1986, the fishery has stabilized and appears to be operating on a sustainable basis.

Although tradable permits are popular in the business community, permits are administratively more complicated and not as well understood as taxes. Edwin Clark, former senior economist with the White House Council on Environmental Quality, observes that tradable permits “require establishing complex regulatory frameworks, defining the permits, establishing the rules for trades, and preventing people from acting without permits.” In contrast to restructuring taxes, something with which there is wide familiarity, tradable permits are a concept not widely understood by the public, making it more difficult to generate broad public support.

Each year the world’s taxpayers provide an estimated $700 billion of subsidies for environmentally destructive activities, such as fossil fuel burning, overpumping aquifers, clearcutting forests, and overfishing. An Earth Council study, Subsidizing Unsustainable Development, observes that “there is something unbelievable about the world spending hundreds of billions of dollars annually to subsidize its own destruction.”

Iran provides a classic example of extreme subsidies when it prices oil for internal use at one tenth the world price, strongly encouraging car ownership and gas consumption. If its $37-billion annual subsidy were phased out, the World Bank reports that Iran’s carbon emissions would drop by a staggering 49 percent. This move would also strengthen the economy by freeing up public revenues for investment in the country’s economic development. Iran is not alone. The Bank reports that removing energy subsidies would reduce carbon emissions in India by 14 percent, in Indonesia by 11 percent, in Russia by 17 percent, and in Venezuela by 26 percent. Carbon emissions could be cut in scores of countries by simply eliminating fossil fuel subsidies.

Some countries are already doing this. Belgium, France, and Japan have phased out all subsidies for coal. Germany reduced its coal subsidy from $2.8 billion in 1989 to $1.4 billion in 2002, meanwhile lowering its coal use by 38 percent. It plans to phase out this support entirely by 2018. As oil prices have climbed, a number of countries have greatly reduced or eliminated subsidies that held fuel prices well below world market prices because of the heavy fiscal cost. Among these are China, Indonesia, and Nigeria.

A study by the U.K. Green Party, Aviation’s Economic Downside, describes the extent of subsidies to the U.K. airline industry. The giveaway begins with $18 billion in tax breaks, including a total exemption from the federal tax. External or indirect costs that are not paid, such as treating illness from breathing the air polluted by planes, the costs of climate change, and so forth, add nearly $7.5 billion to the tab. The subsidy in the United Kingdom totals $426 per resident. This is also an inherently regressive tax policy simply because a part of the U.K. population cannot afford to fly, yet they help subsidize this high-cost travel for their more affluent compatriots.

While some leading industrial countries have been reducing subsidies to fossil fuels—notably coal, the most climate-disrupting of all fuels—the United States has increased its support for the fossil fuel and nuclear industries. Koplow, Douglas|Douglas Koplow]], founder of Earth Track, calculated in a 2006 study that annual U.S. federal energy subsidies have a total value to the industry of $74 billion. Of this, the oil and gas industry gets $39 billion, coal $8 billion, and nuclear $9 billion. At a time when there is a need to conserve oil resources, U.S. taxpayers are subsidizing their depletion.

Just as there is a need for tax shifting, there is also a need for subsidy shifting. A world facing the prospect of economically disruptive climate change, for example, can no longer justify subsidies to expand the burning of coal and oil. Shifting these subsidies to the development of climate-benign energy sources such as wind, solar, biomass, and geothermal power will help stabilize the earth’s climate. Shifting subsidies from road construction to rail construction could increase mobility in many situations while reducing carbon emissions. And shifting the $22 billion in annual fishing industry subsidies, which encourage destructive overfishing, to the creation of marine parks to regenerate fisheries would be a giant step in restoring oceanic fisheries.

We can describe this new economy in some detail. The question is how to get from here to there before time runs out. Can we reach the political tipping points that will enable us to cut carbon emissions before we reach the ecological tipping points where the melting of the Himalayan glaciers becomes irreversible? Will we be able to halt the deforestation of the Amazon before it dries out, becomes vulnerable to fire, and turns into wasteland?

What if, for example, three years from now scientists announced that we have waited too long to cut carbon emissions and that the melting of the Greenland ice sheet is irreversible? How would the realization that we are responsible for a coming 7-meter (23-foot) rise in sea level and hundred of millions of refugees from rising seas affect us? How would it affect our sense of self, our sense of who we are?

It could trigger a fracturing of society along generational lines like the more familiar fracturing of societies along racial, religious, and ethnic lines. How will we respond to our children when they ask, “How could you do this to us? How could you leave us facing such chaos?” These are questions we need to be thinking about now—because if we fail to act quickly enough, these are precisely the questions we will be asked.

Today, more than ever before, we need political leaders who can see the big picture, who understand the relationship between the economy and its environmental support systems. And since the principal advisers to government are economists, we need economists who can think like ecologists. Unfortunately they are rare. Ray Anderson, founder and chairman of Atlanta-based Interface, a leading world manufacturer of industrial carpet, is especially critical of economics as it is taught in many universities: “We continue to teach economics students to trust the ‘invisible hand’ of the market, when the invisible hand is clearly blind to the externalities and treats massive subsidies, such as a war to protect oil for the oil companies, as if the subsidies were deserved. Can we really trust a blind invisible hand to allocate resources rationally?”

In a troubled world economy, where many governments are facing fiscal deficits, these proposed tax and subsidy shifts can help balance the books, create additional jobs, and save the economy’s eco-supports. Tax and subsidy shifting promise energy efficiency, cuts in carbon emissions, and reductions in environmental destruction—a win-win-win situation.